Despite a tumultuous past 11 months, investors probably have a lot to smile about. Following a 34% loss in the broad-based S&P 500 (^GSPC 0.01%) over just 33 calendar days in the first quarter of 2020, the market's benchmark index has been on a tear. It ended 2020 higher by 16%, which is nearly double its average annual return over the past 40 years, and it's pushed to multiple new highs in early 2021.
But what's currently unmistakable about equities is that they're pricey.
As of this past weekend, the S&P 500's Shiller price-to-earnings ratio was just shy of 35. The Shiller P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. This reading of 35 is the second-highest we've seen during a sustained bull market uptrend over the past 150 years. It was topped only by the dot-com bubble, when the Shiller P/E for the S&P 500 surpassed 44.
How exactly does the market support such a lofty valuation in the wake of an unprecedented pandemic and economic downturn? I believe the answer lies with five factors.
1. Improved access to information
Perhaps the most overlooked reason the Shiller P/E ratio has consistently been higher than its long-term mean (16.78) and median (15.81) for the past 25 years is the ease of access to information.
The advent of the internet broke down barriers that existed on Wall Street since its inception. The internet has given retail investors real-time access to income statements, balance sheets, press releases, investor presentations, and management commentary, making it easier than ever to level the playing field. Gone are the days where valuations were held back by a lack of information and catalysts.
2. Historically low lending rates
The stock market's lofty valuation also reflects historically low lending rates. While it's not uncommon for the Federal Reserve to lower the federal funds rate to combat a recession, it's abnormal for the nation's central bank to leave its interest rate target at a range of 0% to 0.25% long term.
The fed funds rate stood pat at 0% to 0.25% for eight years between the end of 2008 and the end of 2016. The nation's central bank moved it back to this range during the coronavirus pandemic. Roughly nine of the past 12 years have allowed businesses to borrow at increasingly cheaper rates, which is fueling innovation, hiring, and acquisition activity.
Furthermore, a lack of inflation-topping yields in investing instruments that are perceived to be safer, like bonds and CDs, offers little incentive for equity investors to cash in their chips.
3. Record stock buybacks
The coronavirus pandemic disrupted this thesis during the second and third quarters of 2020, but in 2018 and 2019, S&P 500 companies were buying back a record amount of stock. Buybacks reduce a company's outstanding share count, which may help improve earnings per share and make a public company appear more fundamentally attractive.
These record buybacks corresponded with former President Donald Trump's flagship tax plan, the Tax Cuts and Jobs Act (TCJA). Under the TCJA, peak marginal corporate tax rates fell from 35% to 21%, which gave profitable companies lots of extra cash to spend. Many chose to repurchase some of their own stock.
4. Fiscal stimulus
More recently, Wall Street and investors have been excited about the federal government's numerous rounds of fiscal stimulus. These stimulus packages have put cash directly into the hands of taxpayers and provided forgivable loans to small businesses to keep them afloat during the pandemic.
The CARES Act, passed in March 2020, cost a whopping $2.2 trillion. In late December, a smaller stimulus package cost $900 billion. With Democrat Joe Biden in the White House and his party now in control of the House and Senate, it's more likely that he'll be able to pass another meaningful stimulus package in the coming weeks or months. The latest proposal introduced by President Biden calls for $1.9 trillion in spending.
Long story short, the more the federal government spends, the more confident businesses, consumers, and investors will be in the inevitable rebound of the U.S. economy.
Finally, don't forget the role emotions play in investing. Even if you subscribe to the Motley Fool ethos of tuning out your emotions and buying great companies for long periods of time, there are more than enough short-term traders in this world to send equities screaming higher or lower at the drop of a pin.
Emotional investing tends to overshoot both the downside and the upside. Panic sends emotional traders to the exit during stock market crashes, while the fear of missing out during major bull markets pushes short-term investors to chase momentum higher.
Eventually, the tide is going to turn. We've witnessed only five sustained rallies above a Shiller P/E ratio of 30 in 150 years, and the previous four did not end well. While this isn't a call to run for cover, it is a reminder to have cash at the ready for when the next stock market crash strikes.